Best Stock for 2008: American Eagle Outfitters

Teens may be fickle, but this stock is solid.

As any parent knows, there's no group as fickle as teenagers -- and companies that target this demographic are often just as unpredictable. But compelling investment opportunities can still be found in the teen retail sector.

For example, clothing retailer American Eagle Outfitters (NYSE:AEO) -- which boasts a strong brand, a shareholder-friendly managerial team, and a cash-rich, debt-free balance sheet -- is an alluring prospect for investors today.

This success is due in large part to AE's executives, who recognized back in 2006 that their primary business unit of mall-based stores was approaching saturation. Consequently, they developed two new concepts to strengthen brand allegiance and stimulate future growth.

The first of these ideas is aerie, which sells pajamas and undergarments to teenage girls. Its products are less sexy (read: more parent-friendly) than the saucy lingerie sold by Limited Brands' (NYSE:LTD) Victoria's Secret, and they have proven to be extremely successful so far. The company currently has around 38 standalone aerie stores, so this remains a huge growth opportunity. I don't think that the possibility of more than 500 stores is out of the question, since the company has nearly 900 core stores.

The second concept, Martin + Osa, was designed to target 25- to 40-year-olds, but it is not sharing in aerie's success so far. Management continues to stress that refining this new brand remains a learning process that will soon yield profitability, and I remain ever so slightly optimistic that these stores will eventually catch on -- but this will definitely take some time.

Two catalysts that ensure successIn the short term, Jay Schottenstein, the chairman of AE's board whose family owns more than 14% of the company, purchased an additional $20 million worth of the company's stock when it took a hit back in August. As any Fool knows, insider buying of this caliber is usually indicative of the presence of value.

In the long run, AE carries no debt on its balance sheet. Instead, it funds the opening of each new store with cash (it currently has $641 million on its balance sheet). So investors needn't worry that the company will be consumed by rapid expansion to the detriment of shareholders' equity.

Competition? What competition?For those who haven't been watching, AE's share price has dropped nearly 35% since the beginning of 2007. One would expect this to indicate that its profitability is in decline, but that couldn't be further from the truth. AE has some of the best long-term margin improvement compared to its primary competitors, Gap (NYSE:GPS), Abercrombie & Fitch (NYSE:ANF), and Aeropostale (NYSE:ARO). And to prove the theory that Mr. Market is not all that wise, these stocks have fared much better year-to-date -- with gains of 9%, 15% and 28%, respectively.

Over the past five years, American Eagle has not only improved its gross margin and return on equity, but it has done so while cutting expenses. Abercrombie and Aeropostale have similarly been able to improve these ratios, but only coupled with ever-increasing spending. Selling at a forward P/E of just 12, AE's stock is priced much lower than these major competitors.

The price is oh-so-rightTo further expand on why AE is currently a lucrative investment, I want to point out that the current share price, hovering between $20 and $21, factors in growth just barely higher than the estimated rate of inflation. While it'd be difficult to argue that AE will continue to grow revenue at rates above 20% as it has done over the past few years, it certainly will grow by much more than 5% annually (analysts estimate 14% per annum) -- meaning that this stock is extremely undervalued, and that now is a great time to buy.

I may not be the most fashionable guy on the block, but this is definitely one stock that is sure to be in style during 2008 -- and I'm not alone in thinking so. The overwhelming majority of the Motley Fool CAPS community also believes this is a stock likely to outperform the market -- so far, it's garnered more than 1,600 bullish votes of confidence. Head over to CAPS now and voice your own opinion on whether this will be the best stock for 2008.

Fool analyst Adam J. Wiederman and The Motley Fool both own shares of American Eagle Outfitters, which is a Stock Advisor recommendation. Gap is both a Stock Advisor and an Inside Value recommendation. Limited Brands is an Income Investor and an Inside Value pick. The Fool has a disclosure policy.